One of the concepts that every student of economics
ought to know - though many fail to grasp its significance - is moral
hazard. Essentially, moral hazard is a behavioural change induced by insurance. People
who have taken out insurance know that if they loose, part of the
loss will be covered by the insurance. This influences their decisions because the insurance changes the risk profile of
alternative options. Put simply, insured drivers are likely to have
more accidents.

Concerns about moral hazards guide a lot of regulatory policy. Many
governments would like to help people experiencing hard times to
help them avoiding poverty. Yet, generous help, say
unemployment benefits, may reduce peoples' efforts to get out of their
crisis themselves. This sort of moral hazard considerations are a
common part
of many debates on regulatory issues.

The
financial crisis has created dilemmas such as these on a much grander
scale. Governments have been bailing out some of the largest
businesses because of their impact on the wider economy, notably banks and, more recently car
manufacturers. The shareholders usually lost out in these bailouts -
as they should, after all they have been reaping the benefits of a
high risk high return strategies when times were good. But does that
resolve the moral hazard issue? Will bank bail outs lead banks to take on more risks than they should? Will car
manufacturers pursue risky growth when then should be downsizing?

Some rescue actions indeed may have caused such
effects. Guarantees and loans aiming to keep business afloat are
likely to create moral hazard problems. Moreover, even in cases of
nationalization, shareholders and other investors often did get more
than nothing (the outcome if bankruptcy was not prevented), even if
they loose a lot.

On the other hand, managers often act in the
shareholders interest only in theory. They pursue their own interests
- which are defined by their own remuneration and power. The real
moral hazard problems seems to have been created by the remuneration
packages for top executives. Incentives schemes such as share options
link top managers' salaries to share prices. Yet, share options imply
an unequal distribution of risks: If things go well, the manager reaps
potentially huge rewards. If things go badly, they may get no bonuses,
but won't loose their own assets. This unequal distribution creates a
moral hazard problems that may induce excessive risk taking. Hence, it
is shareholders that should take action, and introduce better
remuneration packages for the top executives supposedly acting on
their behalf! Notably, share options should be redeemable only after
much longer time periods than is currently the norm.

The crash in the financial markets challenges many
of the assumption of the economics and finance theories that we teach -
at least in the basic models, the 'must knows' for undergraduate
students. In particular, our basic models are build around the
assumption that markets are efficient, and hence prices are fluctuate
randomly around an equilibrium price that reflects supply and demand.
Modern finance theory goes a bit beyond such models to explain
deviations from equilibrium - and thus the possibility of bubbles (Randall Morck gave a great lecture on this topic at the
AIB
conference).

For a long distance flight, I recently picked up
George Soros' updated book on the global economic crisis. Soros is a
well know investor who made billions in financial markets. Yet, if you
expected investment tips, you would be disappointed. Soros is outing
himself as Popperian philosopher, developing what he calls "The Theory
of Reflexivity". Essentially, he is arguing that markets cannot be
efficient because the underlying assumptions about human behaviour
don't hold. Contrary to the natural world, social phenomena are based
on decision makers' analysis of the likely outcomes of their
own decisions. Hence, outcomes are not independent of actions, and
cognitive limitations undermine the supposed rationality of the
decision making. In Soros' own words "knowledge requires a separation
between thoughts and their objects - facts must be independent of the
statements that refer to them - and that separation is difficult to
achieve when you are part of what you seek to understand" (p.26). He
calls this reflexivity, situations where the objective and subjective
aspects do not correspond. This lack of correspondence can lead to
processes where "changes [in the real world] occur as a result initial
misconception or misinterpretation by the participants, introducing an
element of genuine indeterminacy into the course of event" (p.29).

Soros uses his philosophy to explain how financial
markets really work - and the fact that he made a lot of money in
financial markets suggest that he might be on to something
interesting. He rejects the efficient market hypothesis as
inconsistent with human behaviour. More fundamentally, he rejects the
applicability modelling approaches derived from the sciences:
"reflexivity prevents economists from producing theories that would
explain and predict the behaviour of financial markets in the same way
that natural scientists can explain and predict natural phenomena". In
basing decisions on distorted subjective perceptions, market
participants can cause bubbles in financial markets that, as we have
seen in 2008, can a) be huge, and b) affect strategic decisions by
businesses outside the financial markets. 89

My synthesis probably is a bit too simplistic, but
I just wanted to give the gist of the argument. I was reminded of
Simon's concept of 'bounded rationality' - Soros' reflexivity seemed
to be a special case of that. My main problem with his theory is that
it does not lead to an alternative approach to explain and predict
markets. I couldn't work out how he would, given his
philosophy, prevent bubble from emerging, or how he would regulate
markets (given that regulators would be subject to the same cognitive
limitations as market participants). Though recognizing that bubbles
exist, and are in fact quite common, seems to help making
a lot of money.

Soros. G.
2009. The Crash of 2008 and What it Means: The New Paradigm for
Financial Markets, 2nd ed., New York: Publicaffairs.

At times
when all the talk in the UK politics is about long-term government
budget cuts, it is refreshing to see some decision makers - even
politicians - thinking long term. Last night the German parliament
took a decision that merited a small note in the German Press, but is
headline news in the Danish and Swedish Press. After 19 years of
planning and negotiating, the Germans finally said yes to the
bridge over the Femern Belt between the German Island of Femern and
the Danish Island of Lolland. It will cut the travel time between
Hamburg and Copenhagen by an hour, and thus connect both Denmark and
Sweden (itself connected to Denmark by a bridge of similar magnitude)
closer to Europe.

The
financing model is kind of interesting. The Germans only pay for the
upgrading of the motorway and rail link on their side. The Danes build
and pay for the bridge - and in return collect the toll, a rather
unequal distribution of risk and returns. Seems that entrepreneurial
spirits are more alive in Copenhagen then South of the border. I
suspect the Germans will come to regret that ... in about two decades
or so. If you are construction engineer, head for Denmark now, a lot
of work is awaiting!

I suspect
I may become a bit nostalgic when I first travel over that new bridge
in 2018. When I was living in Denmark, the train to Germany always
included a romantic break when the train pulled on the ferry, and one
could swap the train seat with some fresh air and duty free shopping.
That will finally become history.

Once upon
a time, GM was one of the most prestigious companies of America,
producing one in two cars sold in the USA. Yet, that seems like a
live-time ago. Market share has been falling over the decades, and in
recent years even the absolute numbers of cars sold dropped from about
4.5 million cars a decade ago to 3 million in 2008. In the US, GM has
now entered bankruptcy, and the US governments seems to
take over what is left.

In
Germany, GM's demise has played out as a particular drama. GM is one
of the largest car manufacturers in Germany, still using the brand
Opel acquired back in the 1920s. Thus, the crisis in Detroit send not
just employees, but German politicians into panic. One by one they
took to the stage, making promises to their constituents - 'never will
I allow Opel to go bust...'. State-premiers and ministers from both
coalition parties in the federal government all had their interests,
and made their promises. On the other side of the Atlantic, it seems,
smart business negotiators just waited ... and increased their demands
for state guarantees. Eventually, a deal came out that would sell Opel to
Magna of Canada as leader of a consortium also involving Russia Sberbank - with 35% of equity retained by GM. What I couldn't work out
is how they would separate GM and Opel, given the shared model
platforms, technologies and patents, and the tightly integrated supply
chains. Either way, the new company would be economically dependent on
GM for technologies and rights. Somehow it all feels like the German
politicians have been pulled over the table, big time. American
taxpayers should say 'thank you'.

While
politicians were competing to be the rescuer of Opel, one stood up to say stop!
Minister of Economy zu Guttenberg, only recently promoted, tried a
tougher bargain, and got flak from the trade unions in response.
However, counter-intuitively, the latest
opinion polls suggest that zu Guttenberg gets the highest rating from
voters! Perhaps voters do understand that paying huge subsidies to
big business is not quite the best policy.

The Economist 2009: The Bankruptcy of General Motors: A Giant
Fails, June 6th.